Profit Extraction Strategies For 2019/20

Sarah Bradford explores potentially optimal profit extraction strategies for the forthcoming tax year. 

 

The tax year 2019/20 starts on 6 April 2019. The new tax year brings with it new rates and allowances, which will impact personal and family company planning to ensure that profits are extracted in a tax-efficient manner. 

The personal allowance for 2019/20 is set at £12,500; applying equally to Scottish and Welsh taxpayers as well as to those in the rest of the UK.  

 

As in recent years, the personal allowance is gradually abated where income exceeds £100,000; being reduced by £1 for every £2 by which income exceeds £100,000. For 2019/20, this means that those with incomes of £125,000 or above do not receive a personal allowance. 

 

For England, Wales, and Northern Ireland, the basic rate of tax of income tax remains at 20%, the higher rate at 40%, and the additional rate at 45%. The basic rate band is increased to £37,500 and the additional rate applies to taxable income in excess of £150,000. Scottish taxpayers pay income tax by reference to Scottish rates, which range from 19% to 46% depending on the band. 

 

Dividend income for the whole of the UK is taxed according to the dividend rates by reference to the rest of UK bands. The dividend allowance for 2019/20 remains at £2,000, with dividend income (treated as the top slice of income) being taxed at 7.5% to the extent that it falls within the basic rate band, at 32.5%, to the extent that it falls within the higher rate band, and at 38.1% to the extent that it falls within the additional rate band. 

 

Whilst a taxpayer’s personal circumstances will impact on their preferred profit extraction strategy and must always be taken into account, a popular and tax-efficient strategy is to extract profits in the form of a small salary, taking further profits as dividends.  

 

In order to benefit from the full single-tier state pension, an individual needs 35 ‘qualifying years’. Where an individual needs to build up their contributions record, paying a small salary can have the added benefit of securing a qualifying year for contributions purposes without having to actually pay any National Insurance contributions (NICs).  

 

Where an individual has earnings between the lower earnings limit (£118 per week, £512 per month and £6,136 per year for 2019/20) and the primary threshold (£166 per week, £719 per month, £8,632 per year for 2019/20), Class 1 NICs are payable at a notional zero rate. Paying a salary in this band allows the individual to build up a qualifying year for free. For 2019/20, the magic number that achieves this is a salary equal to the primary threshold - £719 per month/£8,632 per year. 

 

Even where an individual does not need to pay a salary to secure a qualifying year (either because they already have 35 qualifying years, or have reached state pension age, or will achieve a qualifying year in another way), paying a salary at this level is still beneficial from a tax perspective where the employment allowance is not in point. This would be the case in a personal company where the sole employee is also a director. In this scenario, assuming the individual has a personal allowance and it has not been used up against other income, the salary would be free of tax. As the secondary threshold for 2019/20 is aligned with the primary threshold, a salary of this level is also free from tax and NICs. Unlike dividends, salary payments are deductible for corporation tax purposes, securing a corporation tax deduction of 19% for financial year 2019. 

 

In certain circumstances, it will be tax-efficient to pay a salary for 2019/20 which is more than £8,632 – but only where it can be paid without an associated tax and employers’ NICs liability. If the employment allowance is available, or the recipient is under 21, a higher salary can be paid without an added employers’ NICs liability. As long as the personal allowance is available in full, where this is the case, it is more tax-efficient to pay a salary equal to the personal allowance for 2019/20 of £12,500. 

 

Paying an additional £3,868 in salary (i.e. so that the salary is equal to the personal allowance of £12,500 instead of the primary threshold of £8,632) rather than taking these profits in dividends is only beneficial where the additional payment is free of employers’ NICs and tax. Although employee’s NICs at 12% (equal to £464.16) is payable on the additional salary, it is deductible for corporation tax purposes, saving corporation tax of £734.92 (i.e. £3,686 @ 19%). The corporation tax saving (£734.92) outweighs the employee’s NICs payable (i.e. £464.16) – a net saving of £270.76. However, once the personal allowance is reached, income tax is payable on any further salary payments, swinging the pendulum in favour of dividends (even if further salary can be paid free of employers’ NICs). 

 

However, if the employment allowance is not available and the employee is over the age of 21, it is not beneficial to pay additional salary in excess of the primary threshold. The combined NICs bill of £997.94 (employers’ NIC of £533.78 (£3,868 @ 13.8%) plus employee’s NIC of £464.16) is more than the corporation tax saved of £734.92. The NICs ‘hit’ is 25.8% and the corporation tax saving is 19%. Therefore, where this is the case, it is preferable to take further profits as dividends if possible. 

 

Unlike salary payments, a dividend can only be paid where the company has sufficient retained profits from which to pay the dividend. Further, dividend payments must be paid in accordance with company law requirements.  

 

Where a company has sufficient retained profits to pay dividends, the starting point is to utilise the dividend allowance. All taxpayers, regardless of the level at which they pay tax, are entitled to a dividend ‘allowance’ of £2,000 for 2019/20. The allowance is a zero-rate band and dividends covered by the allowance are received tax-free. The dividend allowance does, however, use up band capacity. 

 

In a family company scenario, an ‘alphabet’ share structure could be considered to provide flexibility to pay different dividends to different shareholders to utilise any unused dividend allowances and basic rates bands, to extract profits as dividends for minimal tax cost. It should be remembered that dividends have already suffered corporation tax of 19%. 

 

Once the dividend allowance has been used, any further profits extracted as dividends will have an income tax cost. Before taking a dividend, consideration should be given to whether the money is needed outside the company, or whether it is preferable to leave the profits in the company.  

 

The following scenarios examine the tax consequences of withdrawing £20,000 of profits as a salary or a dividend, depending on whether the shareholder director is a basic rate or higher rate taxpayer. 

With profits of £20,000, the company is able to pay a salary of £17,575 (i.e. £20,000 x 100/113.8) and a dividend of £16,200 (i.e. profits of £20,000 less corporation tax at 19% of £3,800).